Short sellers can rake in the bucks when stocks fall, but ordinary investors can profit when short sellers guess wrong. Here's how. By Anne Kates Smith, Executive Editor July 16, 2008 Short sellers sometimes elicit strong opinions among investors. The practice, in a nutshell, involves selling borrowed shares, which the short seller hopes to replace later at a lower price. Because short sellers profit when stocks fall, critics often demonize them as nothing more than nattering nabobs of negativism, in the immortal epithet of Spiro Agnew, Richard Nixon's first vice-president. But ask others and they'll tell you that short sellers keep the market honest by doing the kind of painstaking research that can poke holes in the rationales of analysts who've never met a stock they didn't love -- or want to foist on you.Wherever the truth lies, it's clear that short-selling is a huge part of the market today. Short interest in the stocks that make up Standard & Poor's 500-stock index has risen to a record 3.6% of the shares trading in those stocks -- far exceeding any figure since 1931, according to Thomas Lee, an investment strategist with JPMorgan. Some 36% of S&P 500 stocks have at least 5% of their float (shares that actually can trade) sold short. Some 18% of S&P stocks have more than 10% of their float sold short. Sponsored Content (Steps taken by the Securities and Exchange Commission on July 15 to limit short selling dealt with something called naked short selling. In a naked short sale, which is illegal, someone sells short a stock without first having borrowed it.) But don't let these figures sour you on the stock market. Ironically, the high degree of shorting may be a bullish sign for the market overall. Advertisement "You know the expression, 'the stock market climbs a wall of worry'? Short interest is part of that wall," says Dylan Wetherill, founder of ShortSqueeze.com, a Kansas City, Mo., company that provides short-selling data and analysis to average investors and Wall Street professionals. "Without some pessimism, there aren't enough buyers left to fuel the market. In 1999 and 2000, short-selling was at record lows, while the market was at its peak. Right now, we have a tremendous amount of short-selling in the market. That leads us to think that we're at the bottom." Sustained periods of increasing short-selling tend to run in cycles, according to Lee, lasting 11 months on average and logging an average increase in shares sold short of 28%. Since the current cycle began in October 2007, short interest in S&P 500 stocks has risen 55%, to 10.4 billion shares. If stocks start to rally convincingly -- for whatever reason -- the shorts will, in Wall Street vernacular, get squeezed. That's when the short sellers will be scrambling to buy back their borrowed shares, and that can fuel a significant rally over a brief period. Think of a high degree of short interest in a stock as stored energy, says Wetherill. "When you short it, at some point it has to be purchased back -- one of the only examples in the stock market when buying has to set in." (The exception is when a company goes bankrupt and its stock becomes worthless; in those cases, lucky short sellers never have to cover their shorts, thereby avoiding the taxman.) When short sellers reverse course, it stands to reason that the sectors most heavily shorted benefit most. In late 2001 and early 2002, energy and materials stocks got a lift, Lee notes in a report to clients. Technology stocks were big winners in '03 and '04, and industrials in late '04 and early '05. This time around, financials and shares of consumer-discretionary companies (think homebuilders and automakers) are the most heavily shorted and therefore may present the greatest potential for rewards when the market turns. Advertisement Just about anything could be a catalyst -- good news on the economy or earnings, or merely capitulation of the remaining bulls -- giving stocks nowhere to go but up. "It has obviously been dangerous to be long on equities this year, and contrarians have been hammered," says Lee. He adds, "Given the bearish consensus view and the magnitude of short interest, the bar to trigger short covering appears low." To find promising short-squeeze candidates among individual stocks you need to see high levels of short interest in a stock with newfound strength. Wetherill prefers to look at short interest in relation to average daily trading volume, called the short ratio and expressed as the number of days it would take to cover all the short positions in a stock. He then looks for bullish trading patterns -- a stock trading above its average price measured over a rolling 200-day period or one flirting with a 52-week high, for instance. Opportunities often arise in the volatile tech, biotech and health-care industries. Squeeze candidates Wetherill is watching now include Amedisys (symbol AMED), a home health-care provider. At its July 16 close of $55.74, it trades near a 52-week high, yet it would take 15 days of buying to cover the short interest. Despite recent bad news about its Alzheimer's treatment, Myriad Genetics (MYGN) is, at $59.05, near a 52-week high, with six days needed to cover the shares sold short. Multi-Fineline Electronix (MFLX), which makes smart-phone components, is trading at $25.55, above its recent 200-day moving average. It would require more than five days of buying to cover the short interest. Advertisement JPMorgan's Lee likes to measure short interest as a percentage of shares that trade in a given stock. He has put together a "short-buster's basket" of 35 stocks that are heavily shorted but have recently been upgraded by the Wall Street analysts that follow them. The list is loaded with financial companies, such as commercial banks Wachovia Corp. (WB) and Zions Bancorp (ZION), which closed on July 16 at $10.54 and $23.54, respectively; insurer Loews Corp. (L), trading at $43.35; and real estate investment trust Simon Property Group (SPG), priced at $87.77. Also included on the list: energy names Haliburton (HAL) and Nabors Industries (NBR), which closed at $46.57 and $43.55, respectively; media giant E.W. Scripps Co. (SSP), which closed at $9.31; and discount retailer Big Lots (BIG), with a price of $29.42. Analysts at investment newsletter Dow Theory Forecasts think of high short interest in stocks that they like for fundamental reasons as a potential kicker. A recent screen of some of their favorites found a few with short interest that has been rising in recent months, with the days required to cover the short position above the stocks' historical norms. Among them: Cooper Industries (CBE), a manufacturer of electrical equipment and tools that has been hard hit by the housing decline, closed at $41.72 on July 16. Manitowoc (MTW), which makes cranes for commercial construction and has recently taken on a chunk of debt to acquire an equipment maker to expand its food-service division, closed at $26.73. Wells Fargo (WFC), priced at $27.23, "is the only big bank we're interested in right now," says Dow Theory's Bob Sweet, thanks to its relatively conservative loan strategy.